Hurry up and wait

In a previous post I argued that a lot more work needs to be done by economists to understand the implications of dynamic strategic incentives. Actually, this was an act of shameless self-promotion. Because I have written a paper* together with Philipp Schmidt-Dengler and Yuya Takahashi on strategic interaction and how it can shape the evolution of industries over time.

Industry dynamics is an interesting field. New industries are created by radical innovations and, most often, young entrepreneurial firms doing something completely new. It is interesting to see which of these firms will eventually survive and what are the determinants for successful survival. Who will turn out to be the technology leader in a new class of products? And who is able to enter later, when the industry is already mature, by catching up to the technology frontier?

Number of active firms within an industry according to Utterback and Suarez (1993) and Klepper and Simons (2005, for penicillin).

A phenomenon which, in my view, is very interesting to observe are shakeouts. The first phase of a new industry is usually characterized by lots of firms entering. Everybody wants to have a piece of the cake. But, although overall output in the industry is increasing, after some time, the initial number of firms in the market isn’t sustainable anymore. The industry enters a period of consolidation, which can be very extreme. Figure 1 in our paper gives some examples for shakeouts in the U.S. history.

To not get a wrong understanding, these industries are all quite old. But that is merely a result of data availability. It is difficult, for example, to get recent accounts for the solar industry, which undergoes a shakeout since 2011. Social media is another interesting case where we have already seen exits of first-generation platforms.

What is interesting to economists is that we see shakeouts in many very different industries at different points in time. But they are not a general feature of the industry life-cycle. Why do some industries experience a shakeout whereas others don’t? If firms exit although demand is increasing or at least constant, this means that the optimal firm size is increasing over time. What is the reason for this?

In many cases, the answer is a superior technology. First of all, a few firms must be able to effectively penetrate the market. Then, in order to capture a large market share, a firm must be able to outperform its rivals in terms of prices or quality. But this competition among firms adds a very important strategic component to the phenomenon.

In our paper, we propose a model in which stochastic technology adoption over time raises the efficiency of market incumbents. Firms want to enter the industry early on because, first, this discourages entry of potential rivals, and second, adoption of a superior production technology is only possible while being active in the industry (“learning by doing”, in a sense**). Firms are aware of this fact and know that by entering the industry ahead of their rivals they maximize their chances to become technology leaders. The early years of an industry are thus characterized by a preemption game.

After adoption of the superior technology by some firms, these now more efficient incumbents are able to attract a large market share. They will eventually drive unsuccessful adopters out of the market. The remaining firms, however, which operate with the outdated technology, have an incentive to still remain in the industry for as long as possible. They delay exit and wait to have a chance of also adopting the new promising technology. This results in a war of attrition game in which inefficient firms want to outlast their rivals to obtain one of the few remaining profitable slots in the market. Eventually, after the market has reached a critical mass of efficient firms, prices are so low that inefficient firms are forced to exit.

Note how technological factors in an industry combined with strategic interaction between firms forge the extreme shakeouts that we observe in reality. The preemption incentive at the beginning creates an excess momentum of entry. Firms want to be the earliest and rush into the new market. At a later stage, strategic interaction also causes excess inertia of inefficient firms in a market which is not very profitable for them anymore. The prospects of still achieving a technology breakthrough keeps them in business. Eventually, when these prospects are gone, the remaining inefficient firms exit in large numbers. Therefore, it’s the shift from preemption motives to a war of attrition in a game of technology adoption which is responsible for the severe concentration that some industries attain.

* The paper “Entry and Shakeout in Dynamic Oligopoly” recently appeared as a ZEW Discussion Paper. It can be downlaoded here.

** Technical note: this does not imply that competition on the sport market has direct implications for the dynamic state variables of the model. There holds a static-dynamic breakdown in the style of Ericson and Pakes (1995).